Thursday, 20 September 2012

Pair Trade (Long SVN $9, Short HTHT $14.73)

7 Days Group (SVN) and Chinga Lodging Group (HTHT), which operates as Hanting hotels, are both economy hotel chains growing rapidly in China. Below is a graph of the Enterprise Value/Room ratio of the two hotel chains. The point is to see the relative price you are paying per room when investing in the two chains. The average since May 2010 has been 0.69, meaning you can buy a room in the 7 Days Group chain at a 31% discount compared to an investment in Hanting. Currently the ratio stands at 0.39, meaning a 61% discount!
Reasons for the relative valuation
  • Within the economy hotel industry, HTHT is a premium brand whereas SVN is the thrift brand. In Q2 2012 the average daily rate for a HTHT room was 180RMB vs. 155RMB for SVN.
  • Profitability wise in 2011 SVN earned 7,665RMB/Room based on EBITDA margin and HTHT earned 6,900RMB/Room.
  • HTHT has a larger % of leased and operated hotels vs franchised hotels. (HTHT owns  48% hotels, whereas SVN owns 41% of its' total rooms)
  • Even though both brands are leaning more towards franchised growth, SVN has been following the strategy more aggressively.
  • HTHT delivered a strong Q2 whereas SVN had a relatively weak quarter.
  • HTHT is still smaller with 860 hotels vs 1,130 for SVN making growth easier and faster in the short run. Addition of 100 hotels has a much bigger impact of HTHT at the moment. 
  • These are relatively small cap, illiquid, Chinese equities, with not much mainstream interest creating short-term mispricing. 
I do not expect the relative ratio to reach parity due to some of the reasons stated above, and such a move would be an opportunity to enter the opposite trade. However, the current relative valuation of the two companies is extreme and should return closer to it's historical average of 0.69. A return to the historical average represents a 77% move in the ratio, meaning there is still significant upside potential.

In order for the EV/Room ratio to reach 0.69, SVN would be valued at $16.75, meaning 86% price appreciation from current levels of $9/sh. Or for HTHT to reach the 0.69 average, it would have to drop to $8.37 or a 43% decline from current price of $14.73/sh.

Will update the ratio every month, I'll also add some share price and market cap charts to make it easier to track the pairs performance.

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